This article is an excerpt from Russell Medcraft’s forthcoming book, 'Super Rich: How to create a tax-free income for life', to be published by Wiley in January 2008 www.johnwiley.com.au/trade " This chapter was contributed by Anthony J Cordato to the book.
Property as a superannuation investment
Does property have a place in a super fund? As I discussed in chapter 6, there are arguments for and against. In this chapter, we’ll look at the advantages of property as a super investment. I’ll explain how property works as a tax shelter outside and inside an SMSF, and how to find and acquire suitable property.
If you are reading this chapter, chances are you’re a property person, or you’d like to be one. Some people prefer shares or cash as their investment class of choice, but property people love to invest in property, over and above owning their own home. They usually invest directly, buying in their name or in the name of a company or a trust. Some may invest indirectly in property syndicates or property trusts, or in commercial property. On the following pages I’ll look at the four main reasons that property people are passionate about their investment choice.
Property is low risk
Many people find the fact that you can see the bricks and mortar of property comforting. Property is tangible - you can touch it, unlike shares.
You can minimise the risk of damage to any improvements on the property by taking out building insurance. Public risk insurance will cover any possible injuries.
There are other risks, which can be identified and managed:
- Rental security. Residential property is low-risk in terms of security of rentals. Housing is a basic requirement. Factory, office and retail tenancies are a little more risky, being aligned to the economic health of the business tenant. Proper tenancy selection processes can also reduce tenancy risks.
- Title risk. This is practically zero in Australia, where state governments guarantee land titles and registries are maintained to record interests in property. The guarantee is that the registered owner has full control and entitlements, in terms of renting it out, mortgage and sale.
Property is a hedge against inflation
Inflation favours tangible assets such as property because the value of real assets rises with inflation. If you put $100 into the bank, in five years’ time you will still have $100, with a little interest. If you put that $100 into property, it will always be worth more - and what’s more, the rental price will keep up with the cost of living.
Taking the Reserve Bank of Australia’s inflation target range of 2 to 3 per cent, property values and rents will rise in value annually at an average of 2.5 per cent simply on account of inflation. In fact, headline inflation, as measured by the Consumer Price Index (CPI), rose 2.4 per cent in 2003, 2.6 per cent in 2004, 2.8 per cent in 2005 and almost 4 per cent in 2006.
Inflation detracts from the value of financial assets such as bonds and interest-bearing accounts, which reduce in value by the inflation rate. The interest received must be viewed net of inflation. That is, if the interest is 5.5 per cent a year and inflation is 2.5 per cent, the real return is 3 per cent.
Inflation is only one factor underpinning increases in property values. Other factors include:
- wage increases
- building cost increases
- reducing interest rates
- easy availability finance
- rent increases
- booming local economies.
As a rule of thumb, property prices double every eight to 10 years. Prices can remain flat in some periods and rise strongly at other times. According to the Reserve Bank of Australia, ‘Average capital city house prices have grown by around 175 per cent since the mid 1990s. Prices outside the capital cities have risen by a broadly similar magnitude’ (RBA, Statement on Monetary Policy, February 2007).
But during the same period, rental growth has lagged, going up by between 35 and 60 per cent. The Reserve Bank notes that, as a result of low investment in new property because of low yields, the national vacancy rate is low and rents will continue to climb. In the 1970s and 1980s, a 10 per cent a year inflation rate underpinned unusually high increases in property values and rents. In the 30-year period between 1977 and 2007, a tenfold price property price increase was experienced in many parts of Australia.
Is another burst of inflation around the corner? Property people will be waiting!
Property has low price volatility
Property is a stable investment in terms of price. Property prices can rise quickly - in a boom market, by 20 per cent in three months. But conversely, property prices fall slowly. In a ‘bust’ market, prices may fall by 20 per cent, but this is over a one- to two-year term.
Property does not undergo price fluctuations daily, weekly or monthly, as shares do. But having said that, it’s a long-term investment, largely because of the transaction costs and time lags experienced in the buying and selling of property. It is often considered that seven years is a minimum term for holding property.
Property provides a positive tax environment
Property receives favourable tax treatment, regardless of whether it is bought in a personal name, or through a company, a trust or a superannuation fund. Some of the tax advantages are outlined on the following pages.
Property tax is deferred until sale
The tax on the capital gain in a property is not payable annually, as it would be if it were subject to income tax. Capital gains tax is paid only when the property is sold. The liability to pay capital gains tax can therefore be deferred for many years simply by holding on to the property. Tax deferred is tax saved. The low volatility of property values makes a holding strategy a sustainable strategy. Let’s take a look at an example, to illustrate this point further.
Example 11A unit is bought for $100 000, and sold eight years later for $195 000. Capital gains tax on $80 000 ($95 000 gain less $15 000 expenses) is $18 000 (at 22.5 cents in the dollar). For the eight years the property was held, the $18 000 that would be payable as tax on sale has been retained and used to generate income - at 5 per cent a year the income would be $900 a year. |
Concessional tax rate for capital gains
If the property is owned for 12 months, and if it’s bought in the name of an individual (or the individual receives a benefit from the sale under a discretionary trust), then half of the capital gain (net of expenses) is added on to the taxpayer’s income. Therefore, if the added income brings the taxpayer into the top tax rate of 45 cents in the dollar, because only one half the gain is brought to tax, the effective tax rate will be one half; that is, 22.5 cents in the dollar.
The 50 per cent discount applies for individuals and trusts. A 33.3 per cent discount applies for complying superannuation funds, making the tax rate 10 cents in the dollar. No discount applies for companies.
Tax-free family homes
No capital gains tax is payable on the sale of the family home, as long as the family home is bought in the personal name of an occupier of the home and the occupier lives there.
The proceeds of sale of the family home may be tax-free in some circumstances, such as the owner leaving, the property being sold within 12 months of death, the property having been purchased before 20 September 1985, or a marriage breakdown rollover applying.
Tax benefits for rentals
There are a few things to consider when you’re thinking of renting out your investment property.
Keep in mind that rent is taxable income. Tax is payable on the net amount of the rent, after allowable expenses, not on the gross rent received. The expenses that are deductible include loan interest, repairs and maintenance, council rates, water rates, strata levies, real estate management fees, gardening and rubbish removal.
The most controversial of these expenses is the loan interest expense, which is discussed later in this chapter. We’ll also look at depreciation deduction, which is commonly touted in the sale of new property.
Gear for wealth - but think positive
Gearing is a shorthand term for borrowing against a property. It is generally accepted that borrowing is advantageous for the purchase of a property, where the aim is to build wealth.
This strategy is attractive for wealth creation in the high-income years (when you’re aged 30 to 50), but it can also be used in superannuation funds under some circumstances.
The fact that interest paid on the borrowings will absorb some or all of the rent, and the fact that the property may need to be subsidised using other income, is not important, because surplus income is available from other sources, and the gearing multiplies the gain.
The following example shows how gearing of 80 per cent of the price will magnify the capital gain on cash invested compared with no gearing at all.
Example 12In this example we’ll make the following assumptions about the price |
If the interest expense, when taken together with the other expenses, exceeds the rent, there is a net loss on that property. The loss is known as ‘negative gearing’. The tax laws permit this loss to be applied against a taxpayer’s income from other sources, which reduces the income upon which tax is payable. This is the tax shelter.
Some commentators suggest that the losses from negative gearing be confined to the property, and be available only to offset future rents or capital gains on the property. But when this suggestion was implemented between 1985 and 1987, it was quickly abandoned because investors suddenly pulled out of the market. Rentals also rocketed.
Caution must be exercised on the level of gearing. Negative gearing is to be avoided as it will fetter a person’s income, and constrain them from building a deposit for the purchase of more investment property.
Negative gearing is a bet that the value of the property will increase by more than the money outlaid to pay for the cash flow loss. If this doesn’t happen - which is likely if you buy and sell within five years - negative gearing will result in a loss, even though the property may have increased in value. This is because the money outlaid during the five years has exceeded the increase in value of the property.
The recommended strategy is therefore to be cash flow neutral, or better still, cash flow positive, so that the rental exceeds the interest payments and other property outgoings.
For a positive cash flow investment, tax can be minimised by investing in newer properties and taking advantage of the depreciation, which requires no cash outlay. A relatively new property can have $5000 a year in depreciation benefits, which can then be deducted from tax.
Every part of a building will need repair or replacement in the long run. The fact that the Income Tax Act 1986 allows depreciation to be deducted against income provides a useful reference of how long it will be before an item needs to be substantially repaired or replaced (see the depreciation examples below).
Building depreciation and fittings and fixtures depreciation under the Income Tax Act provide a noncash tax benefit in that these form part of the purchase cost, yet are deductible over many years as an ‘expense’. This benefit only applies to newly built or recently built improvements, although for building depreciation (for buildings after 1983), it continues for 40 years.
Examples of depreciation include:
- building depreciation: 2.5 per cent a year
- bathroom fittings: 5 per cent a year
- kitchen cook tops and ovens: 10 per cent a year
- carpets, linoleum and vinyl: 10 per cent a year
- dishwasher, range hood: 12 per cent a year
- hot water system: 12 per cent a year.
Superannuation as a property tax shelter
Superannuation is the latest tax shelter for property. It is attractive for maximising income during a person’s retirement years from their 60s. Property is a tax shelter in that the rental income and the capital gains are sheltered from full rates of taxation. Income and gains in a super fund are taxed at a concessional rate of tax, 15 cents in the dollar, rather than the individual’s marginal tax rate, which could be as high as 45 cents in the dollar (plus the 1.5 cent Medicare levy).
It works like this:
- Property tax deferral and discount applies. Superannuation funds are not taxed annually on the increases in value of their assets. So an increase in a property’s value will not be taxable until the property is sold. Note that when a complying superannuation fund sells a property, if it has been owned for 12 months, the capital gain for tax purposes is 10 cents in the dollar.
- Expenses and depreciation apply. The normal property deductions are available, being for repairs and maintenance, council rates, water rates, strata levies, real estate management fees, gardening and rubbish removal. Building and fittings depreciation also applies to be offset against rental income. There is no interest deduction, as there are no loans.
- The family home. The family home should never be bought inside or transferred into a superannuation fund. The only exception may be if it ceases to be the family home, but rarely do stand-alone residences make suitable investment properties (as we’ll discuss later in this chapter).
Creative property acquisition
Two main factors should be considered when acquiring property for your SMSF:
- The acquisition must be for the sole purpose of paying benefits to members of the fund when they retire or meet the prescribed age or die. A super fund cannot acquire a holiday apartment for use by members of the fund before retirement.
- The property must be suitable for the super fund to acquire. This is a subjective, rather than a legal, requirement. The property must be suitable in terms of a high rental return and low outgoings and maintenance, so that it can be a long-term ‘hold’.
If the super fund has sufficient cash resources to acquire the property, then it can do so. If not, money can be borrowed through your super fund to finance the property.
In the past, property investors and their accountants put their heads together to come up with some very clever strategies for investors (such as buying property jointly, or becoming a unit holder) to allow their superannuation nest egg to get some leverage and borrow.
Various structures got hit on the head by the regulators and many investors sought to close down their SMSFs because it was too complicated and expensive to keep running trusts that ran alongside SMSFs to borrow money.
That all changed and was made simpler in September 2007, when new laws were introduced giving us the ability to borrow against a new asset that sits in a superannuation fund. Section 67 (4) of the Superannuation Industry (Supervision) Act 1993 was repealed effective 24 September 2007. This section formerly read that superannuation funds were not allowed to borrow. There is now an exception to this, in the form of instalment warrants. The exception means that trustees are no longer prohibited from borrowing money, or maintaining a borrowing, under an arrangement in which the following conditions are met:
- The money is for the acquisition of an asset other than one prohibited by law.
- The original asset - or another asset that is purchased in replacement to the original asset (and that is also not prohibited by law) - is held on trust so that the trustee acquires a beneficial interest in it.
- The trustee has a right to acquire legal ownership of the asset by making payments after acquiring the beneficial interest.
- The rights of the lender against the trustee for default on the borrowing, or on the sum of borrowing and charges relating to the borrowing, are limited to rights relating to the asset.
- If, under the arrangement, the trustee has a right relating the asset (other than a right to acquire legal ownership, as described above), the rights of the lender against the trustee for the exercise of the trustee’s right are limited to rights relating to the asset.
So what does this mean? It is now possible to buy property by instalment. That is, you can use your superannuation as a deposit and the regulated superannuation fund trustee (you) can borrow the rest. The superannuation fund must enjoy a right but not an obligation to acquire the legal ownership of the asset. The definition of asset does not just relate to property but also listed shares, works of art and any other asset that would be appropriate for the trustees.
For an instalment plan to work, you need to establish a debt relationship though a trust. We’ll call this a debt instalment trust (DIT). As a trustee you are precluded from acquiring an asset from a related party. The lender of the money for the purchase of the asset is only limited to the asset as far as their security goes. The lender cannot recover other assets from the superannuation fund in the event of a default.
There is also no limit as to who the lender could be. It could conceivably be the fund itself. This would be ideal for members in pension mode, as they could lend money back to the fund at a notional interest rate, which is commercial. The income will be tax free, but the interest expense could be deductible to the fund because of the instalment contribution.
You need to be careful about the setting up of arrangements to take advantage of the DIT. It’s a good idea to consult an experienced superannuation tax lawyer so that you do not pay unnecessary stamp duty on both the establishment of the trust and purchase of the asset, and the final instalment paid by the super fund, which will then dissolve the trust.
You may be wondering why the legislation been changed to accommodate instalment lending. Instalment warrants have been around for years and have been marketed by the big wealth managers. They have, however, been marketing instalment warrants in a very uncertain tax environment. The new legislation gives us some real clarity around the principles and rules and allows us to apply these principles to other assets.
Acquiring a property with external finance
If your super fund is in accumulation mode, you will often be looking for a gearing strategy with the intent that future contributions into the fund will repay the loan. Let’s look at the various possible scenarios for this.
Unit holder in a unit trust
Until 1998, the commonly accepted means of buying a property for a super fund, with gearing, was for the fund to set up a unit trust, with a corporate trustee, and invest in the unit trust by taking an allotment and issue of units. The following example explains this process.
Example 13A property is to be bought for $300 000 in the name of a unit trust. The super fund subscribes $100 000 and is allotted 10 units with entitlements to income. The unit trust borrows the balance price of $200 000 and the acquisition costs of $15 000. The property is cash flow neutral. |
‘Control’ tests
For investment in unit trusts since 1998, the ATO has applied the ‘control’ test, which means that the beneficiaries of the super fund can’t control the unit trust. So the unit trust must be at arm’s length, which is easy to satisfy for investment in publicly listed trusts, but much harder when the trust is private. The definition of ‘control’ for these purposes is technical, and its examination is outside the scope of this book.
Participant in a property syndicate
Syndicates are property partnerships, but instead of the property purchase being made in the name of the syndicate members, it’s made in the name of a nominee company. Even though the nominee company pays with external finance, and the guarantees of the syndicate members are not required by the financier, the super fund can’t participate in the syndicate unless it has no ‘control’, as defined by law.
Acquiring a property with vendor finance
Vendor finance, in terms of permitting the buyer to pay the purchase price over time, is thought of as ‘finance’ in the broad sense of the word, but does not necessarily constitute a loan.
By this means, a super fund could buy from a third party, and subject to a market valuation to support the price, could buy from a related party. Provided that the instalments add up to the price and no interest is charged, then a transfer by this means should not breach the prohibition on borrowings by a super fund.
Because the title to the property isn’t transferred until completion - that is, when the final instalment is paid - the only documentation is a contract for the sale of land. The contract specifies that the price is payable by instalments - there’s no mortgage.
The seller, if they are a related party, would obtain tax advice to defer payment of capital gains tax until the price instalments are received. The seller may allow the buyer to take the benefit of possession, on the entry of the contract. If the property is rented out, this would mean that the super fund could apply rentals from the property towards payment of the price instalments.
Transfers of property into a super fund are fully liable for transfer or stamp duty, calculated on the value of the property transferred.
In South Australia, legislation applies to limit the number of instalments to four. In Queensland, legislation applies to require the title of the property to be transferred once one third of the price has been paid. The other states have no such limitations.
Suitable property for a super fund
Not all property is suitable for investment, or acquisition by a super fund. The criteria outlined here should be kept in mind when you’re looking for a super investment property.
Maximising income through land content
When considering whether property is suitable for purchase in a super fund, the emphasis should be on maximising income, rather than maximising capital gains.
Income will be maximised when the land content is low relative to the value of the improvements, while income will be minimised when the land content is high and the value of the improvements is low.
Examples of low land content relative to improvements include home units, villas, terrace houses, shops and offices. Examples of high land content include detached houses, vacant land and hobby farms.
Example 14Assume that a two-bedroom house will rent for $250 a week, and the two-bedroom unit next door to it will rent for $220 a week. |
Maximising income by having more than one rental
It may be possible to derive more than one income from a property, by separately renting out parts. The classic example is a shop, with a residence upstairs, which is separately rented.
Perhaps there is also a garage at the rear, which can also be separately rented.
Another example is a split-level house, where the fl at underneath is separately rented. My personal favourite is to build a studio/ garage - which consists of a garage underneath and a studio above - that can be rented out separately from the house/terrace at the street front.
Minimising maintenance
Experienced investors will buy property that doesn’t have large or difficult-to-maintain exteriors. Investors will buy a block of flats, home units, or a row of villas or terraces where there are common walls or it’s all under the same roof.
My father always pointed out that if you buy a house you have four external walls and one roof. If you buy a block of flats you have four walls and one roof - but you have four, six or more rentals from a block of flats, compared with a house, and almost the same external repair requirements in both.
Smart investors will buy property where the building, the fi t-out and the appliances are in good condition and where their useful life can be extended by repair rather than by replacement.
Buildings that are built with low-maintenance materials should be favoured. Following are some tips and traps to look out for:
- Exposed brick is always lower maintenance than painted cement render. Most exposed brick is found externally. Sometimes the exposed brick is internal, where it matters less if it is painted as it is less exposed to the weather.
- Tiled roofs maintain their appearance long after Colorbond, or, worse still, galvanised iron roofs
deteriorate. Skylights last longer if they are glass rather than a polymer. - Aluminium external windows, door frames and screens require less painting than wooden windows and frames.
- Tiled floors in kitchens and dining areas are easier to maintain and last longer than linoleum.
- Wall tiling floor-to-ceiling in bathrooms takes away the need to repaint walls.
- Polished floorboards are, for the most part, far more durable than carpet - particularly if the floorboards are polished professionally, or the carpet is low-quality.
Low-maintenance locations
Experienced investors will avoid buying property in high-maintenance locations. They avoid seaside locations where the salt spray and the salt air will accelerate the deterioration of the exteriors - particularly windows. They will also avoid locations near heavy industry or mining where ‘acid rain’ will accelerate the deterioration of roofing and guttering.
Low-maintenance landscaping
As a rule, tenants don’t look after large gardens or properties. They don’t mow large areas of lawn, don’t keep plants and bushes trimmed and don’t keep fences in good repair. At the end of the tenancy, the cost of bringing the grounds to a good state will often fall upon the landlord, as it is difficult to satisfactorily cover the care and maintenance of the grounds in a lease agreements.
The solution is small yards, easy-to-maintain garden areas and extensive paved areas, which can easily be cleaned up at the end of the tenancy.
The bottom line is that if you follow some basic principles, buy wisely and get good advice, you can follow your passion and use your positive cash flow property to help fund a profitable retirement.